What Are Demo Accounts? Do They Instil Overconfidence In Traders?
Before the introduction of online brokerages, new traders used to attend physical tutorial classes to learn how to trade, and used paper to record all hypothetical trades, positions, and portfolios. This was also known as paper trading.But today, thanks to the internet and software designers, a simulated trading environment can be designed and deployed online for users to download. This is known as demo trading, coined from the word “demonstration” since it’s a demonstration of how trading happens in the real world.
While demo trading is advisable for beginners to get familiar with the market ecosystem, some argue it could instil overconfidence in a new trader. Live trading conditions are quite different from demo conditions and we will discuss why.
Who uses demo accounts and who are they meant for?
Demo accounts are used by both new and old traders. Karan of Safe Forex Brokers UK explains, “Demo trading accounts are meant for traders to test out strategies and learn without risking their money. It is used in all financial markets like Stocks, Forex, Derivatives etc. Day Traders often use demo trading to test their strategies and to see how each scenario would play/work in a real situation before putting in any money.”
Demo trading accounts are designed so that new traders can have a canvas to practice and perfect their strategies before going in with real money. They apply all the theories they have learnt and see the outcome whether profit or loss without worrying about losing their real money.
After a new trader reads about trading and gets familiar with all the jargon such as Spread, Pips, short and long positions, stop-loss orders, etc. They still have to put all that theoretical knowledge to the test.
Demo accounts make new traders conversant with the trading software interface and reduce the nervousness that usually accompanies live trading. New traders know where each button is located, can place orders, and get a general feel of the market. For example, in theory, we know stop-loss orders can be set above or below the price of an asset but demo accounts allow you to practically set the stop-loss and gives clarity to the new trader. Old and experienced traders can also use demo trading to test new trading methods and strategies before they apply them in live trading.
How does a demo account work? How can you use demo trading?
To open a demo account, you simply choose a regulated broker and download their trading app from the online app store or use the web version of the app if you like. The demo account is an integral part of the real trading app so you don’t have to download a separate app for the demo account. After downloading, you fill out all the documentation and open your account. Most brokers do not charge any fee for demo accounts. Your login details are normally sent to your email, and after that, you can activate your account and access it for simulation.
A new trader is assigned virtual trading money and can access the various markets like currency pairs, stock, indices, precious metals etc. provided by the broker. He can also have access to derivative products such as CFDs while demo trading. The environment is simulated to mimic a live trading session and the new trader can place buy or sell orders, set stop-loss orders, etc.
When you log in, you will see live trading and demo trading buttons. If you select demo trading it takes you to the simulated environment and you notice your account has cash in it. That cash is not real and is meant for the simulation. The cash decreases as you open trading positions or record losses and increases when you record profits. If you lose all your virtual cash, you can reset the simulation and start over again.
Why should you use a demo account? How is it beneficial to traders?
Demo trading has several advantages such as:
- Freedom to make mistakes: As a new trader, you can satisfy your curiosity and try out all different scenarios in your imagination without the repercussions of losing real money. While practising, you can update your trading journal and learn from your mistakes.
- Zero risk: Demo trading is completely risk-free so you can try out big transactions running into thousands of dollars without being afraid.
- Building confidence: When you trade and record profits it makes you feel good about yourself and builds confidence when going into live trading
- Practice how to apply risk management tools such as stop orders.
- Test your trading strategies
The conditions are different when you go live
By the time you are through with demo trading and you go live some realities become evident. Some conditions change such as:
When you open a trading position, you need to perform an opposite trade with a counterparty to close your position. In demo trading, a ready counterparty is always available so you execute your buy or sell order speedily at the intended price.
However, in live trading, you might have to queue and wait for a ready counterparty and by the time you find one, the price of the asset may have changed or slipped away from the initial price. This is called slippage and it can interfere with your trading plan and increase your losses or reduce your profits. There is no counterparty risk in demo trading but there is in live trading.
Stop-loss orders could also gap past the stop price in real life forcing you to close your position and execute your market order at another price. In demo trading the conditions are ideal and this may not happen so it will come to you as a shock in live trading and may cause you to record some losses. General platform execution speed could also be slower with longer loading times and this is something new traders will be surprised to find out in live trading.
Fees and commissions
Some demo accounts may not include all the fees and commissions applicable when you are trading live. When you suddenly see certain fees charged during live trading it can throw you off balance and affect your plans.
Demo accounts allow you access to huge capital and when you trade with so much capital you become careless and small losses don’t mean anything to you. However, when you go live, small losses suddenly mean so much since your capital is small and you may be using leveraged funds.
Emotions change while trading live. While demo trading, there’s neither a feeling of fear, greed, nor pain. But all these emotions come alive during live trading. Your emotions awaken from sleeping to actively work against you on the trading floor.
The pain of drawing down and watching your hard-earned money keep reducing and eventually disappear can be difficult to bear. The fact that you find out you are not as good as you thought you were can be embarrassing and, unlike in demo trading, you can’t just reset your system and start again. Things you took for granted in demo trading suddenly begin to matter in live trading and your emotions can cause you to overtrade, revenge trade and sometimes cause you to panic and make a wrong decision.Overconfidence is another emotion to watch out for because making profits in demo trading doesn’t necessarily mean you will replicate the same feat in live trading.
Swing traders who hold positions for several days sometimes have to monitor their open positions and this can be stressful. Day traders also encounter a lot of stress because they have to be monitoring the market constantly. However, in demo trading, you can open positions and go to sleep and come back whenever you like since you know that real money is not at stake. The stress levels in live trading are extremely high.
Does demo trading improve trading skills?
Demo trading gives you a general idea of how to navigate your way and use the trading software but you improve your investing skills through day-to-day live trading and interaction with other traders.
In demo trading, the conditions are designed to be ideal and free from manipulation, re-quoting, counterparty risk, stop- loss hunting etc. But this is not exactly the case in the real world.
The ultimate aim of a demo account is to encourage you to transition to live trading as soon as possible and this is part of the reason it is offered for free. Some rogue brokers may target new traders who are fresh from demo trading school and trade against them knowing they are still overconfident. The conflict of interest between a market maker, broker, and trader means brokers benefit more from a trader’s loss than from a trader’s gain. When picking a broker, take your time and also focus on low fees rather than low spread.
Should you trade live if you are successful in demo trading?
Probably not! Karan from Safe Forex Brokers advises that, “it is not guaranteed that you will get the same results in live markets, as emotions come into play when real money is invested. Also, trading conditions might differ in live, depending on the data feed and platform provider.”
“One must practice for at least six months and start with small capital that they can afford to lose once trading live for the first time to test out any strategy.”
Moreover, day trading can be risky in live markets and requires time tested strategies and years of experience. It is better to invest for the long term rather than do day trading if you are a new investor.
Beginners must also avoid markets and instruments like derivatives, CFDs, Commodities and forex as these are more volatile in nature and require years of experience to learn and perfect trading strategies and style.